Have a plan. Follow the plan, and you'll be surprised how successful you can be. Most people don't have a plan. That's why it's easy to beat most folks.
No rational traveler would ever take a trip to a place he has never been without a road map and directions. Similarly, no rational businessperson would start a business without spending lots of time and energy thoroughly researching that business and then developing a well-thought-out plan. Investing is no different. It is not possible to make a rational decision about any investment without considering how the addition of that investment would impact the risk and return of the entire portfolio, and thus the odds of achieving the plan's objectives.
There is an old and wise saying that those who fail to plan, plan to fail. Yet, many investors begin their investment journey without a plan, an investment policy statement (IPS) laying out the plan's objectives and the road map to achieving them. The IPS includes a formal asset allocation identifying both the target allocation for each asset class in the portfolio and the rebalancing targets in the form of minimum and maximum tolerance ranges. A written IPS serves as a guidepost and helps provide the discipline needed to adhere to a strategy over time.
Just as a business plan must be reviewed regularly to adapt to changing market conditions, an IPS must be a living document. If any of the plan's underlying assumptions change, the IPS should be altered to adapt to the change. Life-altering events (a death in the family, a divorce, a large inheritance, or the loss of a job) can impact the asset allocation decision in dramatic ways. Thus, the IPS and resulting asset allocation decisions should be reviewed whenever a major life event occurs.
Even market movements can lead to a change in the assumptions behind the IPS and portfolio's asset allocations. For example, a major bull market, like the one we experienced in the 1990s, lowered the need to take risk for those investors who began the decade with a significant accumulation of capital. At the same time, the rise in prices lowered future expected returns, having the opposite effect on those with minimal amounts of capital (who were perhaps just beginning their investment careers). The lowering of expected returns to equities meant that to achieve the same expected return investors would have to allocate more capital to equities than would have been the case had returns been lower in the past. The reverse is true of bear markets. They raise the need to take risk for those with significant capital accumulation, while lowering it for those with little. A good policy is to review the IPS and its assumptions at least annually.
Because it outlines and prescribes a prudent and individualized investment strategy, the IPS is the foundation of the investment plan. Meir Statman, a behavioral finance professor at Santa Clara University, notes the importance of psyches in investment behavior, likening the situation to antilock brakes. "When at high speed, the car in front of us stops quickly, we instinctively hit the brake pedal hard and lock 'em up. It doesn't matter that all the studies show that when the brakes lock, we lose control." Statman suggests investors need antilock brakes for their investment portfolios as well.
Instinctively we react to investment situations in ways that might have saved our lives fighting on distant battlefields long ago. But, today they are counterproductive, like locking up our brakes. When the market drops, our instinctive fear to flight is so strong, even the most rational investors find themselves caving in, to their own demise. And market tops can often be called soon after the staunchest of bears throws in the towel and turns bullish.[1]
An IPS can act as an investor's antilock braking system. Your own IPS will provide you the discipline to stick with your plan and reduce the risk of emotions (greed and envy in bull markets or fear and panic in bear markets) from impacting the decision-making process.
Before writing an IPS, you should thoroughly review your financial and personal status. Financial situation, job stability, investment horizon, tolerance for risk, and need for emergency reserves vary from investor to investor and change over time for each individual. The IPS should not be developed in isolation. It should be integrated into an overall financial plan, one addressing investments and the entire spectrum of risk-management issues (creditor protection and the need for life, health, disability, long-term care, liability, and even longevity insurance).
The written IPS should include a list of your specific goals, such as the rate of return you are trying to achieve, the amount of additional assets you are planning on adding to your portfolio each year (assuming you are in the accumulation phase), the amount of assets you are trying to accumulate by a certain date, when you plan to begin withdrawals from the portfolio, and the dollar amount (or percentage) you plan on withdrawing each year. This will allow you to track progress toward the goal, making appropriate adjustments along the way.
The next step is to specify the asset allocation, first identifying how much will be allocated to equities and how much to fixed income. Within these two broad categories, you need to establish the appropriate percentage allocations for each of the individual asset classes, such as small cap, value, and emerging markets. Next, list the ranges within which you will allow market movements to cause the designated allocation to drift before you will rebalance the portfolio. (See Table 2.1.) The process of rebalancing is discussed in Chapter 11.
Table 2.1. Sample Rebalancing Table
Minimum Allocation (%) | Target Allocation (%) | Maximum Allocation (%) | |
|---|---|---|---|
U.S. large | 7.5 | 10 | 12.5 |
U.S. large value | 7.5 | 10 | 12.5 |
U.S. small | 7.5 | 10 | 12.5 |
U.S. small value | 7.5 | 10 | 12.5 |
Real estate | 7.5 | 10 | 12.5 |
Total U.S. | 45 | 50 | 55 |
International large value | 3.75 | 5 | 6.25 |
International small | 3.75 | 5 | 6.25 |
International small value | 3.75 | 5 | 6.25 |
Emerging markets | 3.75 | 5 | 6.25 |
Total international | 15 | 20 | 25 |
Total equity | 65 | 70 | 75 |
Nominal bonds | 7.5 | 10 | 12.5 |
TIPS | 15 | 20 | 25 |
Total fixed income | 25 | 30 | 35 |
Investment plans should consider both the expected returns on equities and bonds and the possibility that returns could be well below those expectations. For example, it is likely that in January 1990 few Japanese investors expected Japanese large-cap stocks to produce overall negative returns over the next nineteen years. Another example: U.S. large growth stocks produced negative returns for the ten years from 1999 through 2008—an occurrence unprecedented since 1938.
Since we know that severe bear markets are likely to occur from time to time but cannot know how long they will last, a critical part of the financial planning process is developing a contingency plan (Plan B), a plan of action implemented if a "black swan" (a major unexpected event) appears. The plan should detail what actions should be taken if financial assets fall to such a degree that investors run an unacceptably high risk of failure. For example, the portfolio may run out of assets if Plan A is not adapted to the existing reality. Or it may be that the investors have an important bequeath goal they don't want put at risk, such as a special-needs child.
Plan B should list the actions to be taken if financial assets drop below a predetermined level. Those actions might include remaining in or returning to the workforce, reducing current spending, reducing the financial goal, or selling a home and/or moving to a location with a lower cost of living. Consider the following example.
It is 2003, and Mr. and Mrs. Brown are each fifty years old. Mrs. Brown is a successful doctor; Mr. Brown is a college professor. They plan to retire at age sixty. Working with their adviser, they decide that their risk tolerance means holding a portfolio with a "worst case" cumulative loss of 25 percent. Thus, they decide to set their equity allocation at 60 percent. Based on historical evidence, the Browns know there is a reasonably high probability their portfolio will not experience a cumulative loss of more than 25 percent. However, they also know it is possible a greater loss could occur. A Monte Carlo simulation (see Glossary and Chapter 16) shows their plan has a 92 percent chance of success.
The mistake many investors make is to focus solely on the high odds of success and ignore the odds of failure. That is the same mistake as not buying life insurance because the odds of dying in the near future are so low. The Browns do not make that mistake. They recognize the possibility of failure exists, but they do not plan on that scenario as the "base case."
Using the worst case as the base case means that ability to take risk is low, so returns are going to be low. Therefore, investors making the worst case their base case will reduce risk but have significantly less to spend in retirement than if they had not done so and the worst never happened.
The Browns had worked hard, saved well, and wanted to enjoy the rewards of their efforts. But they did not ignore the risk of the possibility of "failure." They agreed with their adviser that if a bear market occurred, resulting in a new Monte Carlo simulation producing odds of success of less than 85 percent, they would consider taking some or all of the following steps, depending on the size of their losses:
sell their second home
reduce their daily spending requirements by 10 percent
reduce their travel budget by 50 percent
continue working until at least age sixty-five
move to a region with a lower cost of living
While the Browns hoped they would never have to execute any of these steps, they did recognize the risk that it could be necessary, and they were prepared to do so.
Only list options you are actually prepared to take. Listing ones you really won't exercise will cause you take too much risk in the first place. Write down your options. It will help you determine which ones are truly real.
Returning to our example, for the next five years the Browns lived well and enjoyed their lifestyle. When the 2008 financial crisis hit, they were well prepared to take the steps needed to prevent their plan from failing.